Interest Rates on the Rise

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The world is on a Keynesian spending spree. Western central banks are inflating as never before in peacetime. Western governments are running massive budget deficits.

The European Union in 1997 established a Stability and Growth Pact, which set guidelines for fiscal policy: an annual deficit of no more than 3% of GDP and a total government-debt-to-GDP ratio of no more than 60%.

The West is far beyond both limits. In a March 20 speech by a senior IMF official, we read the following.

In advanced economies, reducing unemployment is a priority. At the same time, however, public debt is piling up to unprecedented heights, creating worries in many advanced countries about fiscal sustainability. In fact, IMF analysis indicates that advanced economy fiscal deficits will average about 7 percent of GDP in 2011, and the average public debt ratio will exceed 100 percent of GDP for the first time since the end of World War II.

As is increasingly obvious, such a fiscal trend simply is not sustainable. While expansionary fiscal policy actions helped to save the global economy from a far deeper downturn, the fiscal fallout of the crisis must be addressed before it begins to impede the recovery, and to create new risks. The central challenge is to avert a potential future fiscal crisis, while at the same time create jobs and support social cohesion.

He is a standard Keynesian economist. He stated without qualification that “expansionary fiscal policy actions helped to save the global economy from a far deeper downturn.” He assumed that his listeners would agree with him. This has been the Keynesian party line ever since 1936. It is not questioned. But now the acceptance of the Keynesian party line has removed all resistance to fiscal deficits on an unprecedented peacetime level.

“The central challenge is to avert a potential future fiscal crisis, while at the same time create jobs and support social cohesion.” This is like saying, “Governments need to pursue policies of black and white – no gray.” According to Keynesians, the fiscal crisis can be overcome by economic growth. But governments still pursue massive deficits, and central banks inflate. No Keynesian is willing to say, “Enough is enough. The economy is now on a path to self-sustained recovery. It is time to implement an exit strategy for both the deficits and monetary expansion.” On the contrary, they call for extending the deficits. They praise the central banks’ willingness to buy the IOUs of national governments.

The speaker was straightforward in his assessment of what must be done. The problem is, there is no major political party that will do this.

The immediate fiscal task among the advanced countries is to credibly reduce deficits and debts to sustainable levels, while remaining consistent with achieving the economy’s long-term growth potential and reducing unemployment. Achieving the fiscal adjustment alone is no small task: The reduction in advanced economies’ cyclically adjusted primary budget balance that will be needed to bring debt ratios back to their pre-crisis levels within the next two decades is very large – averaging around 8 percent of GDP – although there is considerable variation across countries. Large gross financing requirements – averaging over 25 percent of GDP both this year and next – only add to the urgency of creating credible medium-term fiscal adjustment plans.

Urgency? What urgency? There is no sense of urgency. The deficits climb, the debt-to-GDP ratios climb, and politicians show no sign of being willing to reverse this.

Low interest rates have saved Western economies from suffering serious restraints on fiscal policy. This will not last much longer, he thinks.

This combination of rising debt but stable debt service payments is not likely to continue for long, however. Higher deficits and debts – together with normalizing economic growth – sooner or later will lead to higher interest rates. Evidence suggests that an increase in the debt-to-GDP ratio of 10 percentage points is associated with a rise in long-term interest rates of 30 to 50 basis points.

He identified the #1 problem: spiraling costs for government-funded medicine. The problem is, this is politically untouchable. He knows this. He failed to mention it. Instead, he merely described it.

To be credible, any advanced economy fiscal consolidation strategy must deal with the cost of entitlements that are a if not the key driver of long-term spending pressures. Of course, health care-related spending reforms will have to form a central part of any budget strategy. New projections by IMF staff show that for advanced economies, public spending on health care alone is expected to rise on average by 3 percent of GDP over the next two decades. Thus, for any budget consolidation plan to be credible, it must deal with the reality of rising health care costs. Inevitably, successful reforms in this area will include effective spending controls, but also bottom-up reforms that will improve the efficiency of health care provision.

Credibility is as credibility does. Western governments are doing nothing to bring these deficits under control. By this standard, the promises and assurances of politicians in the West are incredible.

This is the elephant in the living room. An IMF official at least mentioned its presence. He of course offered no suggestions as to how the elephant should be removed, or who will attempt to remove it. That is for politicians to decide.

Politicians have decided to let the elephant occupy the living room indefinitely.

Voters are unaware of the problem. They think that this elephant can be dealt with. But elephants must be fed, and their waste must be removed. By whom?


Medicare for years has been running a deficit. This deficit has been funded by the general fund. The trustees expect this to continue. But they offer hope. The system will not be busted until 2029. By “solvent,” they mean that the Trustees will not run out of nonmarketable IOUs to sell back each year from the Treasury, which has to come up with the money to buy these IOUs, year by year.

The trustees also make a major assumption. The legislation of 2010 will reduce Medicare costs, as promised. This was the Patient Protection and Affordable Care Act as amended by the Health Care and Education Reconciliation Act of 2010 (the “Affordable Care Act” or ACA).

Much of the projected improvement in Medicare finances is due to a provision of the ACA that reduces payment updates for most Medicare goods and services other than physicians services and drugs by measured total economy multifactor productivity growth, which is projected to increase at a 1.1 percent annual rate on average. This provision is premised on the assumption that productivity growth in the health care sector can match that in the economy overall, rather than lag behind as has been the case in the past. This report notes that achieving this objective for long periods of time may prove difficult, and will probably require that payment and health care delivery systems be made more efficient than they are currently.

Anyone who believes that passing that law is going to reduce Medicare costs probably also believes that the elephant in the living room will soon go away of his own accord. The trustees know better, so they covered their backsides: “This report notes that achieving this objective for long periods of time may prove difficult.” May prove difficult! Indeed!

The handwriting is now on the wall, written in red ink. No one seems to notice. The king does not call for a modern-day Daniel to translate. The message is in a foreign tongue: digits. The king does not call in the accountants to translate, because he knows what they will say. The message is much the same as it was in Daniel’s day: MENE, MENE, TEKEL UPHARSIN. TEKEL means the same: “You have been weighed in the balance and found wanting.”

Any politician who openly says, “It’s time to cut back on Medicare,” will find himself out of a job after the next election. The insurance companies welcomed Medicare as a way to get high-risk oldsters off their rolls. They kick you off when you turn 65. They will not pay for anything that Medicare would pay for. You can stay on the rolls by paying high premiums, but you will not be paid.

There is no way to go back. The elephant will remain in the living room. He will grow. He will consume more. The pile of dropping will increase.

Everyone in high places knows how this will end: in default. No one is willing to say the form that the default will take.

Some think it will end in hyperinflation. But that does not end the program. It will still be there on the far side of T-bill repudiation.

Some think it will be the unwillingness of central banks to buy government debt. They will cease inflating That will cause Great Depression 2.

Some think the oldsters will finally be cut off and returned to their children for medical care. At today’s Medicare costs, that will be $11,000 per year of added insurance fees, which private companies will refuse to insure for people with existing conditions.

Someone will pay to get the elephant out of the living room. The taxpayers will not bear the costs of Medicare indefinitely.


John Maynard Keynes wrote in the depths of the worldwide depression. His most famous book was published in 1936: The General Theory of Employment, Interest and Money, soon captured the minds of younger economists. A decade later, Keynes died. At the time of his death, it was clear that his explanation of the Great Depression would become dominant.

In 1948, the first edition Paul Samuelson’s Economics textbook appeared. It became the dominant textbook in the West. It was called neo-Keynesian. That is, it was only partially incoherent, unlike Keynes’ General Theory, which is totally incoherent. (Skeptics who think I am exaggerating have either never read The General Theory or have spent years reading textbooks to prepare them to believe they understand The General Theory when they read it after they have received their Ph.Ds in economics.)

Keynes’ publisher, Macmillan, had published Lionel Robbins’ excellent book, The Great Depression, in 1934. It was short, readable, and theoretically accurate. It is online for free here.

In 1937, Macmillan published another book on the causes of the depression, Banking and the Business Cycle, by three economists. It is online for free here.

If these two books had carried the day in the economics profession, the West would be far richer today, if we assume that decisions made by private property owners are more efficient than decisions made by politicians and central bankers, none of whom can be held personally economically accountable for the outcome of their decisions. These two books were coherent, accurate, and committed to the free market. They are forgotten today. Were it not for the Mises Institute’s program of online posting and physical reprinting of out-of-print books on free market, they would probably not be available.

The world’s economists are allied to the politicians. They defend massive government deficits as necessary to avoid recessions and unemployment. But unemployment is higher than anything since the Great Depression. The policies have clearly failed. Nevertheless, apologists use the familiar argument from counter-factual history: the rate of unemployment would be much higher today if it had not been for the deficits and central bank inflation. This needs to be proven. They do not attempt to prove it.

The Keynesians have been given a free ride by non-Austrian School economists. While economists gripe about this or that minor technical detail about the deficits and the central bank inflation, there is no full-scale critique of these policies by mainstream economists. They have bet the farm on the positive outcome of the policies.

The rise of commodity prices testifies to a growing problem. Price inflation apart from energy and food has remained low. Energy and food prices are dismissed as irrelevant in the medium-term, because they are volatile. They go down, too. But when price categories do not go down, as these two have not ever since late 2008, the statisticians are supposed to incorporate them into their statistical model. Government statisticians are resisting this.

As the rise in prices forces a rise in interest rates, debt will become a major drain in consumer spending. Consumers respond to rising monthly expenditures by cutting back on borrowing. Governments do not. They call on the central bank to intervene and buy bonds with newly created money. This cannot go on much longer. The inflation premium in the bond market will increase.

Government is absorbing the savings of Americans. The sink holes that constitute the Federal government’s constituencies will absorb the money that would otherwise have gone to finance businesses. Economic growth will slow. Then it will become contraction.


The IMF bureaucrat ended his speech with this.

In sum, there is no doubt that given the evolution of the recovery, countries are grappling with increasingly-complex and increasingly-diverse challenges. This is certainly true of fiscal policy. But to move toward a future of strong, sustainable, and balanced growth, these fiscal challenges need to be addressed urgently. The time for action is now.

Thank you for your attention.

The problem: no one in power is paying attention. The time for action is now, he said. Salaried economists have been saying this for years. But no one takes any action.

Government debts will increase until rates go up. Then lenders will still lend. Private capital will suffer. It will be crowded out at the governments’ low rates.

The Federal Reserve System is buying most new Treasury debt today. The monetary base is rising. Monetary inflation is increasing. Price inflation is increasing. This is why interest rates will be going up.

If you are in debt for anything on a floating-rate basis, you are in trouble.

March 24, 2011

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2011 Gary North